Apple Has Room To Get Worse Before Getting Better

By Stephen D. Simpson, CFA | January 23, 2013 AAA

With December quarter earnings in hand, Apple (Nasdaq:AAPL) is no longer perfect nor flawlessly reliable. Given the sheer scale of the company and the never-ending deluge of articles, columns and opinions on Apple, there's definitely some risk now from jilted and scorned Apple lovers turning from their favorite stock. Though there's considerable apparent value in the shares at this level, investors should not ignore the risk that there could be a few more knocks to the story before the stock retrenches and investors re-evaluate its long-term potential.

SEE: A Primer On Investing In The Tech Industry

A Disappointing Start to Fiscal 2013
Referring to Apple as a "disappointment" always needs to be done in context, as there are many companies that will never approach Apple's performance, even at the peak of their operating history. Nevertheless to those whom much is given in market cap, much is expected in performance.

Revenue rose 18% from last year and 52% from the prior quarter, but that was nevertheless just a bit below the average sell-side guess for the quarter. Sales from the iPhone and Mac businesses both looked a little disappointing, as the iPhone saw revenue increase 28% and Mac revenue fell 16%. Revenue from the iPad increased 22%, while iPod revenue declined 15%. Apple's iTunes segment reported 22% higher revenue, while sales from accessories improved 25%.

Profits were a mixed bag as well. Gross margin declined about six points from the year-ago level, but were basically in line with expectations. Likewise, the company's operating income declined slightly from last year's level, but was in line with what analysts generally expected.

SEE: Apple iWatch: Is It About Time?

Is Execution Now on the Table As an Issue?
When I was asked to outline some bearish theses on Apple, one of the issues I cited was the potential for disruptions in the company's order patterns was a sign of emergent execution issues. With this quarter in hand, I still have that same concern.

Mac sales were weak at least in part due to product shortages. Likewise, the company apparently saw some supply constraints for its iPad mini. That's not very Apple-like. Now let me be clear - I am NOT suggesting that Apple is heading down the Nokia (NYSE:NOK) / Research In Motion (Nasdaq:RIMM) spiral, but my point is that when a company has a reputation for delivering an almost flawless execution, odds are good that the next turn is going to be in a negative direction, and maybe we're seeing a bit of that now.

Could Margins Take a One-Two Punch?
Margins could also be an issue for Apple in the near future. I do believe that if Apple really wants to continue to post large revenue growth numbers and rule the mobile device world, it needs to launch more lower-priced products, particularly to capture the Asian smartphone opportunity. Unfortunately, smaller devices tend to bring smaller margins.

I am also interested in what may happen with components. Apple has been the beneficiary of a very tough pricing environment for chip and electronic component companies in recent years, and I don't believe that can last forever. Now, major suppliers such as Broadcom (Nasdaq:BRCM) and Qualcomm (Nasdaq:QCOM) are not talking about meaningful ASP improvements right now, but I do wonder if Apple needs to look out for rising memory and component prices over the next 18 months or so.

SEE: 3 Ways To Indirectly Invest In Apple

Riding the Cycle
Last but not least, I could see Apple taking some more licks from competitor product launch cycles. It looks like there is going to be a bevy of new ARM Cortex-A15 smartphones over the next four or five months, while Apple likely won't be making major releases until mid-year or later. None of this is new - there has been a market-share dance between Samsung Electronics and Apple tied to launch timing for a while now - but it's not going to do anything to help the sentiment.

The Bottom Line
Although this piece has been geared toward what can go wrong for Apple, that is largely because I believe there is never any shortage of alternative "How Apple can rule the world" pieces out there for investors to read. For what it's worth, I'm still broadly positive on this company - there is plenty of ground left to cover with smartphones and tablets, and even if Apple is losing some of its hardware/feature edge, it still has a very strong ecosystem (iTunes, Apple stores, etc.) to support its products.

What's more, valuation doesn't seem all that demanding. Let's assume a bearish scenario where Apple's free cash flow margin retreats back into the low 20%s and then into the teens (say because it's due to margin compression). And let's say that Apple's forward revenue growth such that the long-term compound annual growth rate is about 7%. That leads to an unimpressive-looking free cash flow growth rate of about 2 to 3% - but even with that growth rate, fair value is north of $700 and well ahead of today's price.

The biggest risk to Apple, in my opinion, is perception. Regardless of what sort of cash flow it produces, tech stocks with low growth don't get their due in the market and the market is pretty clearly worried about Apple's growth prospects. While I'd let the dust settle here, Apple could be setting up as a very interesting stock for patient value/GARP hounds.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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